Rising yields in European bond markets, partly triggered by the tapering of the ECB’s asset purchase programme (QE) by the end of 2018 will ripple across the eurozone banking sector (see: ‘The End Of QE: Risks To Italy And The Eurozone Periphery’ Oct 15). This will affect capital ratios, funding costs and asset values. The ECB will end QE by end-2018 as policymakers are increasingly more comfortable with the trajectory of the economy as well as a slow normalisation of prices. Despite the ECB’s pledge to keep its main policy rate at current ultra-low levels (0.00%) until at least mid-2019, and the fact that the central bank is still active in the bond market, the widening spread between peripheral economies’ bond yields over German yields suggests that pressures in bond markets are building. Italy and Greece have been particularly affected in the last two months (see chart below).

Spread Between Italian and Greek 10-Year Bond Yields Over Equivalent German Bonds

Source: ECB, Fitch Solutions

Banking Sector To Be Impacted Via Three Channels

The planned tapering of QE will gradually affect bank profitability via three main channels: lower bond prices, wider lending-deposit interest rate spreads, and higher loss provisions on impaired loans as the QE-induced boost to growth subsides. Lower bond prices will reduce bank asset values which, in combination with renewed upward pressures on non-performing loans (NPLs) due to a slowing economy could affect banks’ capital buffers and their loss-absorption capacity. After three years of ECB bond-buying, the amount of bonds on eurozone banks’ balance sheets have significantly decreased. Nonetheless, corporate and sovereign bonds still account for a sizeable share of banks’ total assets. In this respect, Italian, Spanish and Belgian banks will be the most vulnerable to yield fluctuations, as government bonds account for approximately 16.5% of their total assets (see chart below).

Banks Will Remain Vulnerable To Yield Fluctuations Due To Their Sizeable Bond Portfolio

Bond Portfolio, % of total assets

Source: ECB, Fitch Solutions

Banks will tighten lending criteria in a bid to safeguard their capital buffers. On aggregate, the eurozone banking sector fully meets the Basel III capital requirements. At 16.0% and 15.0%, the average Tier 1 capital ratio and the average leverage ratio are well above the Basel III-mandated ratios of 6.0% for the former and 3.0% for the latter. Although credit growth has accelerated over the past three years to 1.9% year-on-year (y-o-y) in the first eight months of 2018 from just above 1.0% in 2016, evidence from the 2011 European debt crisis suggests that banks tend to ease downside pressures on their capital and reserve ratios by reducing lending. This means that banks could start curtailing the supply of credit to the real economy should lower bond prices increasingly weigh on their capital ratios. In terms of our forecasts, we expect client loans to expand by 1.8% in 2018, and to start softening thereafter to 1.7% in 2019 and 1.6% in 2020 (see chart below).

Client Loans Growth Set To Decelerate

Eurozone – Client Loans

f = Fitch Solutions forecast, Source: ECB, Fitch Solutions.

Lending-Deposit Rate Spreads Will Widen

A steeper yield curve will widen lending-deposit rate spreads. This will help to support bank profitability, partly offsetting the downward pressure on banks’ profits stemming from lower bond prices. By pushing down long-term yields over the past three years, QE has steadily narrowed the spread between lending and deposit rates, squeezing banks’ net interest margins. In contrast, the winding-down of the QE programme should gradually widen the rate spread over the coming years. This will support interest margins and profitability, as banks usually borrow at shorter-term rates and lend for longer durations at higher interest rates. In the first three weeks of October, the spread between the 10-year and the 2-year government bond yield widened to an average of 160 basis points (bps) in Italy, Spain, Ireland and Portugal (see chart below). We expect the yield curve to continue to steepen going forward as the ECB’s reduced activity in the bond market puts upside pressure on long-end yields.

Spreads Between 10-year and 2-year Government Bonds On The Rise

Spreads Between 10-Year & 2-Year Government Bonds, Bps

Source: ECB, Fitch Solutions

A Rise in NPLs Will Weigh On Bank Credit Growth, Especially In Peripheral Economies

Against a backdrop of slightly softening growth, we expect a rise in NPLs will affect banks’ ability to extend credit going into 2019. We forecast real GDP growth to decelerate in 2018 and 2019, coming in at 2.0% and 1.8% respectively, down from 2.5% in 2017. Dovish ECB policy has been one of the primary drivers of the recovery in the eurozone over the past few years, and we believe that the end of asset purchases will add to already weakening activity across the eurozone’s core member states, which is highlighted by faltering coincident and leading high-frequency indicators. In line with this, we note that the composite eurozone Purchasing Managers’ Index (PMI) readings remain on a downward trajectory (see chart below), suggesting that growth is now well past its peak (see: ‘Eurozone Growth Slowing As Expected’ Jul 31).

PMI Pointing To Weakening Momentum

Eurozone – Composite PMI

Source: Markit, Fitch Solutions

In countries with weaker macroeconomic fundamentals, such as Italy and Greece, a potential reversal of the hitherto downward trending NPL ratios could have adverse effects on banks in the form of depressed earnings due to write-offs, weaker credit growth, rising loan loss provisions while potentially impairing their ability to raise funds on the market. NPL ratios have been on a steady downward trend across the eurozone throughout the last four years (see chart below). European Banking Authority data shows that at the end of Q218, three countries still had NPL ratios of more than 10.0% (Greece: 44.8%, Cyprus: 34.1%, and Portugal: 12.4%), while all other EU Member states had NPL ratios of less than 10.0%. 19 Member States even reported NPL ratios of less than 5.0%. Despite the ongoing downward trend, macroeconomic fundamentals in some peripheral economies, Italy and Greece in particular, remain weak and we would not be surprised to see a pause (and even a reversal) in the declining trend in NPLs, especially if the end of the ECB’s bond-buying programme will adversely affect GDP growth more that we are currently anticipating.

NPL Ratios Downward Trajectory Set to Reverse

NPLs, % of total loans

Note: 2018 = Q218. Source: EBA, Fitch Solutions

The Italian Banking Sector Will Remain The Most Vulnerable

The Italian banking sector has been under significant pressure since the eurosceptic League-Five Star Movement coalition government took power in May 2018. Since then, the Italian bank has index dropped by approximately 35.0%, falling to its lowest level since mid-2016. There are three main reasons for this. First, Italian banks remain highly exposed to fluctuations in yields as they still hold a substantial proportion of government debt, which accounts for approximately 16.5% of total assets, one of the highest shares in the eurozone. Second, Italian banks are perceived as relatively riskier than most of their European counterparts given the high (albeit steadily declining) stock of NPLs, which currently stand at 9.7% of total loans, down from 16.5% in 2016. Rising credit default swap (CDS) prices and a widening spread between Italian and Spanish CDSs (see chart below), both suggest significant government bond holdings and a still relatively high level of NPLs will leave Italian banks in a weak position to deal with any QE tapering-triggered bond sell-off.

The Cost Of Insuring Italian Debt Against Default Has Increased Significantly

Italy, Spain – Credit Default Swap Spread, bp

Source: Eurostat, Fitch Solutions

Finally, concerns over impaired lenders’ ability to dispose of NPLs via government-backed securitisation schemes due to growing political turbulence will remain a key source of bearish sentiment towards Italian banks.